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Booming demand for thematic exchange-traded funds, evidenced by massive flows in 2020 that have continued into this year, is raising concerns about their impact on values and liquidity in the market.

As more retail investors look for gains in funds that cover themes from e-commerce and clean energy to cloud computing and cannabis, analysts say the influence of these ETFs on the micro- and small-cap categories they’re invested in is cause for caution.

“Thematic investing is past the tipping point,” says Mark Yamada, president and CEO of PUR Investing Inc., a software development and consulting firm specializing in tools that help investors use ETFs effectively and manage risk.

Where ETFs once attracted larger investors for their broad exposures, low cost and tax efficiency, Mr. Yamada says they’re “starting to appeal to a wider audience, and thematic investing is part of that” as people look to outperform the index.

A recent research note co-authored by Citi analyst Scott Chronert found that the “nearly parabolic” popularity of thematic ETFs in 2020 is likely to carry on as “investors continue to demand more precise positioning” and seek post-pandemic opportunities.

The report, titled Thematic Comes of Age, says there were US$57-billion of flows into U.S. thematic ETFs last year, with a total of US$140-billion in assets under management in the category at the end of 2020. Thematic ETFs attracted more than US$32-billion just in January and February of this year, Bloomberg reports, and a survey released in March by Brown Brothers Harriman & Co. found that 80 per cent of global ETF investors plan to increase their exposure to thematics this year.

This popularity could come at a cost. The Citi report looked inside thematic ETFs to determine their most common, most owned and most concentrated underlying stocks and found that ETFs owned up to 25 per cent of some small- and micro-cap stocks. This could cause liquidity problems if there’s a sudden selloff in those particular equities.

“There can be a footprint left from ETF trading in smaller, illiquid segments of the equity market,” says David Kletz, vice-president and portfolio manager at Forstrong Global Asset Management Inc. It’s therefore important, he says, to be aware of the structure of the ETFs you invest in. “Be comfortable with what you’re buying.”

The biggest concern is whether huge ETF flows might distort the price of their underlying stocks, Mr. Kletz says. “ETFs work much better when they are a means to participate in a rally but they aren’t further propelling the rally.”

There have been concerns that the recent sizable ETF inflows may have an impact on the overall market, but Mr. Kletz says the category remains relatively small. However, small- and micro-cap stocks that focus on emerging technologies linked to powerful disruptive trends do tend to have significant ownership by thematic ETFs.

Mark Noble, executive vice-president of ETF Strategy at Horizons ETFs Management (Canada) Inc., says thematic ETFs allow investors to make “theme calls” rather than picking individual stocks that might end up tanking. Just think if, back in the day, you could have invested in mobile computing as a category rather than buying shares in the darling but doomed Palm Pilot, he points out.

Valuations of some stocks are mighty high, Mr. Noble allows. For example, he says his company’s Horizons Marijuana Life Sciences ETF HMMJ-T, one of the largest thematic ETFs in Canada, is doing well even though “stocks in the portfolio overwhelmingly have negative earnings... People are taking on big bets on the potential of these companies to grow their earnings in the future.”

Mr. Noble says many investors are attracted to thematic ETFs because of the “classic fear of missing out” on huge returns. “You’re going to see lots more of them,” he predicts. Investors should ensure these funds fit with their risk-reward profiles and, indeed, “you have to be almost psychologically prepared to lose that whole position,” he says. “With massive eye-popping returns comes eye-popping risk.”

Mr. Noble, for example, has limited his own exposure to thematic ETFs to 10 per cent of his holdings. When a thematic ETF he was invested in did particularly well recently, he sold off part of the assets to maintain that 10 per cent cap. “Absolutely invest in some themes, but be sure your core portfolio is built,” he says.

Mr. Kletz feels that 2020 was a “high-water mark” for thematic ETFs inflows, noting that the “big winner” has been the ARK Investment Management family of funds. Its ETFs have an additional managed approach rather than being “passive index-following vehicles,” albeit with somewhat higher fees. For example, its hugely popular ARK Innovation ETF ARKK-A has a management expense ratio of 0.75 per cent, which is relatively high in the ETF universe.

Mr. Yamada says earlier-stage companies are one area where more active management does appear to beat the broad indexes, which is why thematic ETFs where the underlying structure is constructed and controlled appear to make sense.

However, the concentration of thematic ETFs in upstart under-the-radar companies brings greater volatility, so they “have to be used very judiciously,” he says. “Buying the broad market with the core of your portfolio is always the right thing to do,” Mr. Yamada says. This means investing in index funds with low fees, “which is why you buy ETFs in the first place.” For Canadian investors, he says, it’s also important to include U.S. ETFs that cover the S&P 500 and Nasdaq 100 indexes to get good exposure to technology names.

An “explore” portion of your portfolio can be earmarked to “reach for extra performance,” Mr. Yamada adds. “You can take your mad money – money you’re willing to lose entirely – and play some of these themes for fun.”

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